By Emily Dorisio

Recently issued proposed regulations provide guidance on how to determine when a distribution by a partnership (including LLCs taxed as partnerships) to a service partner is really a disguised payment for services rather than a distribution of a partner’s distributive share of partnership income. Service providers in the context of start-up businesses, investment fund partnerships or private equity investment in partnerships often accept a “profits-only” partnership interest in lieu of fees for their services to defer recognition of income and possibly convert what would otherwise be ordinary income to capital income. These arrangements need to be structured properly to avoid being recharacterized by the IRS as a disguised payment for services. A recharacterization impacts the tax allocations to all of the partners,  not just the service partner, and raises issues of whether the service partners is more properly characterized as an employee or independent contractor and whether the partnership complied with appropriate information reporting and withholding obligations.

The proposed regulations lay out six non-exclusive factors that indicate when an allocation and distribution between a service partner and a partnership should be treated as a payment for services rather than a distribution of a partner’s distributive share of partnership income. They are: (1) the arrangement lacks significant entrepreneurial risk, (2) the service partner holds or is expected to hold a transitory partnership interest or the partnership interest for a short period of time, (3) the service partner receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service provider would typically receive payment, (4) the service partner became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third-party capacity, (5) the value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution and (6) the arrangement provides for different allocations or distributions with respect to different services received, the services are provided either by one person or persons that are related and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

Whether an arrangement constitutes a payment for services depends on all the facts and circumstances, but the most important factor is lack of significant entrepreneurial risk. If there is no significant entrepreneurial risk, the arrangement will be considered a payment for services. If there is significant entrepreneurial risk, the arrangement will generally not be a payment for services unless the remaining factors establish otherwise. The weight given the remaining factors depends on the particular arrangement in question and the absence of a factor will not necessarily be indicative of whether an arrangement is or is not payment for services. The proposed regulations provide several examples of the application of the above factors to a specific set of facts.

For more information, please contact Emily Dorisio of our Lexington, Ky. office at 859-899-8714.